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Petrodollar 107: The Coming Petrodollar Collapse?

19 Jan 2016

When I wrote the original Petrodollar series, I had thought that I was done once I’d posted part 6. However, I was then told repeatedly that I’d missed out the last part of the story. That is: what happens if/when the Petrodollar System collapses?

So, if this is the first time you’re reading this, here’s the backstory*:*although you probably only need to read Petrodollar Wars 106 for the summarised historical timeline.

Petrodollar Wars 103: the Collapse of Bretton Woods – including a list of the various ways to arbitrage gold, how the gold standard forced America into the Triffin Dilemma, and how Mr Nixon suddenly and unilaterally told the French (and everyone else) to sod off.

The primary global currency of reserve (the American Dollar) operates off a Petrodollar (Oil) Standard.

Because oil trade is denominated in dollars, you can be pretty sure that the dollar will maintain its value as long as:

The world needs oil; and

The oil trade continues to be denominated in dollars.

And that’s not just a demand-for-oil story. It’s the other side as well:

As the oil-producing countries get paid in dollars, so they need to invest the dollars somewhere.

That place is American Financial Markets, because those markets are the only ones big enough to take those levels of investment.

So the Oil Trade ensures a steady and constant demand for American (financial) products.

Because the Oil Trade has created a status quo for dollar trade, and because most countries will therefore keep some of their Foreign Reserves denominated in US dollars (in order to pay for oil imports), the natural tendency is then to denominate most international trade in dollars.

And the American people, by consuming plenty of imports, are actually helping to reinforce the dollar’s global dominance.

So, now, what happens if:

The Oil-Producing Countries decide that American Markets are too risky; and/or

We run out of oil, maybe?

Actually, maybe we should start by asking: “how likely are either of those scenarios?” Because, to my mind, the answer is “not very”.

The Oil-Producing Countries may well dislike the risk of American Markets – but they don’t exactly have a long list of alternatives. 40 years of investing oil surplus into the American financial markets have left them giant. A little googling gets to an answer of around 25% of the world’s capital being held in America’s financial markets. The other (less but still) big markets: Japan, Europe, China. One of those seems poised on the hyperinflation brink (thanks, Abenomics, thanks), another beset by general political and economic crisis, and the last closeted and running out of water. And (breathable) air. None of those sound especially appealing.

And more than that – if any of said countries attempted to break with the US dollar on oil, or any of the rules around it… Well just look at Iraq.

And as for Peak Oil and Oil Reserves

Peak Oil? We’ll die from Climate Change long before that happens. Or we’ll run out of water and food. Also, there’s the small fact that “proven oil reserves” (the figure that gets thrown around when someone from Forbes decides to be alarmist) actually refers to oil that companies are actually drilling for in existing fields.

…[and you’ll notice the USA looking all depressed about its small allocation]…

What you must remember is this:

That said, is there anything to suggest that the other big Oil Reserve players don’t face a similar outlook?

Well – there is an economic aspect to this. If you pay attention, you may notice that oil reserves go down when the oil price is low and they go up as the oil price increases… And that’s because the market price of oil determines how “recoverable” a particular well of oil is. At a higher oil price, the more difficult-to-access reserves might be extracted, meaning that those will count toward oil reserves. At a lower oil price, they won’t.

And in the United States, oil and gas law puts limits on what can be extracted from an oil well. In the rest of the world, those limits are either non-existent, or much higher. What does that mean? It means that significant US oil “reserves” are not economically feasible to extract, so they get excluded from proven oil reserve statistics*.*the more oil you can pump out of a well per day or per year or whatever, the more oil revenue you have to cover the costs of extraction… After all, the big costs are capital investment and fixed salaries. Those costs won’t change with the volume of oil extracted.

As a long-term strategy, that does seem to suggest that the United States is setting itself up to be a future dominant player in energy. Presumably after she’s consumed most of what the other big players can extract.

But let’s assume that the Petrodollar System collapses anyway

What would happen?

Nothing.

At least – not for a while:

As a result of inertia, pre-planning, and general custom, most global trade would already be planned to take place in US dollars, with multiple forward and futures contracts already in place.

There are no real alternatives for large-scale financial investment, so the world would have to wait for a secondary market to develop and become accepted.

The oil-producting nations, China and Japan would be holding large amounts of dollar reserves, so those countries would have a vested interest in the petrodollar system perpetuating, or at least emerging in an alternative form.

Whatever nay-saying might be out there, I think that the important point to remember is that “the petrodollar collapse” scenario is very similar to what people were expecting when the US dollar left the Gold Standard.

But when the dollar left gold, the dollar stayed the global currency of reserve for years in the interim while the Petrodollar system was developing…

So I think that we should all be more concerned by the threat of Climate Change. And/or the crisis of the world’s impending water shortage.

Comments

The Petrodollar series is one of the most lucid and useful explanations available anywhere. New, here we are, nearly two years since this last installment on the Petrodollar collapse, and a couple of Black Swans later, with a New World Order underway. I wonder if there a case for a revision in this final chapter?

The game changers that are in play, but not addressed in this informative and reassuring essay are the new structural realities that have put the Petrodollar in some jeopardy, including:

The new Gold-Yuan convertible oil trading currency designed deliberately to help nations of the world avoid the Dollar in oil trades — both the oil importing and producing nations. This new trading currency will be introduced at the end of 2017.

This is connected with the rise of Eurasia and the emergence of multipolar world power across the Eastern Hemisphere. It promises to mitigate the disruptive and economically damaging US-led sanctions against other sovereign nations, The change includes the replacement of SWIFT with CIPS, for obvious reasons. Another facet of the Yuan-Gold trade is the capture of Saudi Arabia’s oil by this larger and expanding Eurasian non-Dollar trading alliance, perhaps inspiring all of OPEC to uncouple from the Petrodollar arrangement. This market is bolstered by funding from the AIIB infrastructure bank, which is underwriting the modern OBOR trading routes, opening new markets across eastern Europe and throughout Asia, Africa, and South and Central America.

With its easy liquidity, easy settlement, and easy convertibility to gold, the Gold-Yuan bond may be suitable for all foreign trade, all at a lower net cost. Perhaps central banks will no longer need to hold vast Dollar reserves, giving them more autonomy. This system was put in place specifically to end Dollar hegemony, and to economically constrain US military expansion and intervention, which has been the hallmark of its quest for Empire over the world. As popular as that aspiration might be in some circles in the US, the rest of the world may not be as enthusiastic for US rule.

Is the Petrodollar now part of the past? Or is that still a long way off? I do hope you keep this extraordinary series going.

I have three main worries about how the future of oil and dollar dominance will play out. The first is that reserves (and the petrodollar system) are only useful if the oil price is maintained. Given the environmental limits, this seems unrealistic. There is a very neat article here:

As a result of these limits, the world is agreeing to change energy systems. Sure it’s taken 40 years to make little steps but the renewable energy revolution is definitely on it’s way. More and more car manufacturers are promising to switch sources and renewables keep beating the IEA predictions for uptake. Combine that with this very interesting (and I think logical) prediction for the future of urban transport:

And you very definitely have a logical recipe for moving away from oil. (That might explain the US reluctance to ratify the Paris agreement.)

Second, the level of QE seems astronomic in the last decade. I’m not an economist but to me the numbers look pretty scary and the long term dollar devaluation has to come some time, right?

Third, chuck in some cryptocurrency confusion into the mix (I believe it has value because it is better than most currencies – sure it is pure speculation at the moment but the utility will follow).

I’ve no idea how that all plays out but I suspect we are in for interesting times. In the very long term, crypto looks extremely dangerous (permanent global deflation?) but for the next 30 years or so, I think it’ll shine.